FTC Issues Rule Banning Non-Compete Agreements, While Business Groups File Suit Challenging the Rule

On April 23, 2024, the FTC approved a rule banning businesses from including post-employment non-competition covenants in the vast majority of employment contracts nationwide. The rule provides that it is an unfair method of competition in violation of Section 5 of the FTC Act for employers to enter into a non-compete agreement with a worker, whether an employee or an independent contractor. Once the rule goes into effect, existing non-competes will no longer be enforceable, except for those that apply to “senior executives.” The rule also includes an exception that will permit non-competes in connection with the sale of a business. Employers will also be required to notify workers by the date that the rule becomes effective that existing non-competes are no longer enforceable unless they are subject to either of the above-referenced exceptions.

Key Takeaways

The rule has drawn attention and controversy since it was proposed in January 2023. During the public comment period, the agency received over 26,000 comments. The FTC stated that 25,000 of them supported a comprehensive ban. However, concerns have been raised over whether the FTC has the authority to promulgate such a sweeping rule. The FTC Commissioners split 3-2 along party lines on the final vote to issue the rule. The rule is slated to go into effect in late August 2024, 120 days after it is published in the Federal Register.

Under the rule, a non-compete clause is defined as a term or condition of employment that “prohibits a worker from, penalizes a worker for, or functions to prevent a worker from” seeking different employment or operating a different business. Notably, the definition includes contractual terms that “function to prevent” new employment. For example, while the FTC indicated that a nondisclosure agreement, a training repayment agreement, a non-solicitation agreement, a return of property agreement, or any other similar restrictive employment covenant would not typically be covered by the rule, such a covenant could still be unenforceable under the rule if it is “so broad or onerous that it has the same functional effect” as a non-compete.

Exceptions to the Rule

• Existing Non-Competes for Senior Executives: Employers may continue to enforce existing non-competes for senior executives, defined as employees in a policy-making position who earned at least $151,164 in the preceding year. “Policy-making authority” is defined as final authority to make policy decisions that control significant aspects of a business entity or a common enterprise. According to the FTC, less than 1% of workers will qualify as senior executives, but it is anticipated that there will be practical and legal challenges to interpreting who qualifies as a senior executive under the rule. After the rule goes into effect, employers will be barred from entering into new non-competes with senior executives.
• Sale of a Business: Non-competes entered into in connection with a bona fide sale of a business are exempt, provided that the sale includes “the person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.” The FTC’s proposed rule included a 25% ownership threshold, but the final rule jettisoned that requirement. While this exception has been broadened in the final rule, the FTC made clear that such non-competes are still subject to relevant state laws as well as federal antitrust law.
• Existing Causes of Action: The rule does not apply where a cause of action related to a non-compete clause accrued prior to the effective date of the rule.
• Exempt Entities: The FTC recognized that the final rule does not apply to entities that are not subject to the FTC Act, including certain financial institutions, common carriers and nonprofit entities. Notably, however, the FTC has taken the position that, even if an entity is a registered nonprofit for tax purposes, it may still be subject to the rule if it is a profit-making enterprise or organized for the profit of its members.

Finally, the FTC’s rule preempts conflicting state laws but does not otherwise restrict states’ ability to regulate non-competes. Employers must still comply with state laws.

Arguments Behind the Challenge

As expected, on April 24, 2024, the US Chamber of Commerce and other business groups filed a lawsuit seeking to block the implementation of the rule. The case was filed against the FTC and FTC Chair Lina Khan in the United States District Court for the Eastern District of Texas, arguing that the rule is unlawful. The case has been assigned to Judge J. Campbell Barker, who recently struck down a rule promulgated by the National Labor Relations Board (see Chamber of Commerce v. NLRB, 2024 WL 1203056 (E.D. Tex. March 18, 2024)).

Specifically, Plaintiffs argue that the rule is unlawful for four main reasons:

• The rule exceeds the FTC’s authority under the FTC Act. Specifically, the FTC lacks the authority to issue regulations prohibiting substantive competition rules (as opposed to procedural rules) because Congress has not “empowered the [FTC] with general rulemaking authority.” Any doubt about the FTC’s authority would be resolved by the “major-questions doctrine”, which courts have invoked to reject attempts by administrative agencies to undertake significant actions based on ambiguous or ancillary statutory authority.
• Even if the FTC has authority to issue such regulations, a non-compete agreement is a common business practice and should not be categorically unlawful.
• The rule is “impermissibly retroactive,” as the FTC lacks the authority to issue retroactive regulations and raises Fifth Amendment concerns.
• The rule is “an arbitrary and capricious exercise of the Commission’s powers.”

Plaintiffs seek, among other things, a permanent injunction prohibiting the FTC from enforcing the rule and an interim order delaying the effective date of the rule pending resolution of the litigation.

What’s Next?

We expect additional suits to be filed. The rulings in these lawsuits will not only impact whether the rule becomes effective, but will impact the scope of the FTC’s rulemaking authority.

This rule closely aligns with existing law in California, which has a long and robust history of prohibiting non-compete agreements under state law. A group of O’Melveny practitioners recently published an article examining what California’s experience can teach us about a world without non-competes. The article analyzes the strategies that California businesses have used to protect their legitimate interests without relying on non-compete agreements and the case law that has developed in response to these efforts.

O’Melveny’s Antitrust & Competition and Labor & Employment teams continue to track developments as the law on non-competes evolve. For any questions related to the rule or non-compete issues, please contact the O’Melveny lawyer whom you work with or one of our Key Contacts.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Julia Schiller, an O’Melveny partner licensed to practice law in the District of Columbia, New Jersey, and New York; Anna T. Pletcher, an O’Melveny partner licensed to practice law in California; Eric Amdursky, an O’Melveny partner licensed to practice law in California; Kim Williams, an O’Melveny partner licensed to practice law in Texas; David Almeling, an O’Melveny partner licensed to practice law in California; Ramon Ramirez, an O’Melveny counsel licensed to practice law in California; Ryan Rutledge, an O’Melveny counsel licensed to practice law in California; and Mike Rosenblatt, an O’Melveny associate licensed to practice law in the District of Columbia, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

© 2024 O’Melveny & Myers LLP. All Rights Reserved. Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York’s Rules of Professional Conduct to O’Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, T: +1 212 326 2000.